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Great Income, With a Catch

We have long been fans of floating-rate bank-loan funds because they offered better yields than other short-term bond funds without ratcheting up the risk. It turns out, though, that the funds are riskier than we and others had assumed. Over the past year to March 10, the average bank-loan mutual fund has lost a confidence-shaking 6.8% (that figure includes the funds' interest payments). Among closed-end funds, which trade on exchanges like stocks do, the average loss on share price was a stiff 16%.

The losses have more to do with declining confidence in the bond market in general than with specific problems in the bank-loan market. No one knows when things will return to normal for bonds, but the downside for bank-loan funds appears limited. And once the funds begin to recover, they will once again deliver handsome returns to investors who have strong stomachs.

These funds invest in loans that are often issued to finance buyouts. Although borrowers' balance sheets are less than stellar, such loans are fully secured by company assets, and lenders are first in line for payment in case of bankruptcy. The terms of these loans range from six to eight years, and interest rates reset every 60 days or so.

A year ago, investors couldn't get enough of bank loans and, as a result, they changed hands for a premium to their face value. But the collapse of the subprime mortgage market has changed the picture. Now bond buyers are avoiding any type of risk and are piling into government-backed securities. "The selling seems pretty emotional to me," says Scott Page, who manages open-end and closed-end bank-loan funds for Eaton Vance. "The quality of loans in my portfolio is more or less the same as it has always been."

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Tempting yields. Falling short-term interest rates have exacerbated the problem by making floating-rate funds less attractive in general. But yields on bank-loan funds have actually risen because the value of their assets has plunged (yields move inversely with prices). So Fidelity Floating Rate High Income (symbol FFRHX), which we have dropped from the Kiplinger 25 because of higher-than-expected risk, now yields a tantalizing 7.5% (see The 25 Best Funds.

Another reason loan values have fallen is the fear that the current low default rate (about 1%) could soar in a recession. But Christine McConnell, manager of the Fidelity fund, calculates that bank loans are now changing hands at prices that reflect a 10% default rate -- a level not seen since late 2001. Even when borrowers default, banks still recover an average of 79% of a loan's value, she says. That historical recovery rate should put a floor under loan prices. In fact, prices have firmed to about 90 cents on the dollar since dipping to as low as 85 cents earlier this year. "Money will move back to the loan market when people are confident in the underlying value of the assets," says McConnell.

Given the discounted prices on bank loans, closed-end funds look compelling. For example, at a mid-March price of $5.49, ING Prime Rate Trust (PPR) trades at a 9% discount to the already diminished value of its assets and yields 9.5%.

There's a caveat, however: Closed-ends borrow money to boost returns, and one way to borrow is to issue preferred stock that is bought and sold at periodic auctions. But many of these auctions have failed recently because of a lack of bidders -- another symptom of the turmoil gripping the bond markets. These auction failures have the potential to increase borrowing costs and thus reduce closed-end dividends. If you're tempted by the seemingly compelling values in these funds, you should keep that in mind.